Book Description

Equity returns are more dependent in bear markets than in bull markets. This phenomenon known as asymmetric dependence is well documented in many previous studies including Erb et al (1994), Longin and Solnik (2001), Ang and Bekaert (2002), Ang and Chen (2002), Das and Uppal (2003), Patton (2004) and references therein. By reformulating the extreme exceedance correlation result of Longin and Solnik (2001) in an equivalent fashion as tail dependence, we show analytically that a multivariate GARCH model or a regime switching (RS) model based on normal innovations cannot reproduce this asymmetric dependence. We propose an alternative model which allows tail dependence for lower returns and keeps tail independence for upper returns. This model is applied to international equity and bond markets from two pairs of countries, the two leading markets in North-America (US and Canada) and two major markets of the Euro zone (France and Germany) to investigate their dependence structure. It includes one normal regime in which dependence is symmetric and a second regime characterized by asymmetric dependence. Empirical results show that the dependence between equities and bonds is low even in the same country, while the dependence between international assets of the same type is large in both regimes. The cross-country dependence is specially large in the asymmetric regime. This phenomenon possibly is due to the nonlinearity in dependence of international returns characterized by the presence of extreme dependence that is absent in the tail of a multivariate normal distribution. Exchange rate volatility seems to be a factor contributing to asymmetric dependence. With the introduction of a fixed exchange rate the dependence between France and Germany becomes less asymmetric and more normal than before. High exchange rate volatility is associated with a high level of asymmetry. Monte Carlo Tests confirm the presence of asymmetric dependence in both pairs of countries.